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DETERMINATION OF FORWARD AND FUTURES PRICES 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 1

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CONSUMPTION VS INVESTMENT ASSETS Investment assets are assets held by significant numbers of people purely for investment purposes (Examples: gold, silver) Consumption assets are assets held primarily for consumption (Examples: copper, oil) 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 2

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SHORT SELLING Short selling involves selling securities you do not own Your broker borrows the securities from another client and sells them in the market in the usual way At some stage you must buy the securities back so they can be replaced in the account of the client You must pay dividends and other benefits the owner of the securities receives 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 3

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DETERMINATION OF FUTURES PRICES Futures prices are determined competitively by equality of supply and demand. However, we can often use arbitrage arguments to obtain simple expressions. These arguments are simplified by ignoring differences between forward and futures prices - the two are the same if the rate of interest is constant: Cox, Ingersoll and Ross (1981), The Relation between Forward Prices and Futures Prices, Journal of Financial Economics, 9, 321 - 346. Jarrow and Oldfield (1981), Forward Contracts and Futures Contracts, Journal of Financial Economics, 9, 373 - 382. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 4

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THE ARBITRAGE PRINCIPLE If two strategies, A and B, have identical returns in all states of the world, they must cost the same. Suppose they had different costs, C A > C B : one may short A and long B to make an initial profit of C A - C B instantly and risklessly. The arbitrage principle requires: no transaction costs no restrictions on short selling the market participants can borrow money at the same risk-free rate of interest as they can lend money. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 5

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ALTERNATIVE WAYS TO BUY STOCKS Outright Purchase: Simultaneously pay the stock price and receive ownership of the stock Fully Leveraged Purchase: A purchase in which you borrow the entire purchase price of the security. Prepaid forward Contract: An arrangement in which you pay for the stock today and receive the stock at an agreed-upon future date. Forward Contract: An arrangement in which you both pay for the stock and receive it at an agreed-upon date and price. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 6

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ALTERNATIVE WAYS TO BUY STOCK Example: Stock price at time 0 is Difference is the time to take the ownership. If you defer payment, you should pay interest. DescriptionPay at timeReceive Security at time Payment Outright00S 0 at time 0 Fully LeveragedT0S 0 e rT Prepaid Contract0T? Forward ContractTT?*e rT 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 7

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PREPAID FORWARD CONTRACTS ON STOCK A prepaid forward contract entails paying today to receive ownership at a future date. The sale of a prepaid forward contracts permits the owner to sell an asset while retaining the ownership of the asset for a period of time. Buyer of the contract will get the ownership in the future. If there is no dividend payments, then price of the prepaid contract is the stock price today. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 8

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PREPAID FORWARD CONTRACT Or alternatively we can derive the prepaid forward contract price using present value. For a non-dividend paying stock, the prepaid forward price is the stock price. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 9

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PRICING PREPAID FORWARD CONTRACT BY ARBITRAGE Arbitrage is defined as profit by simultaneously buying and selling related asset. Since there are many market participants, we should not see any arbitrage opportunities (risk-free profit). Assume that price of stock in future will be S T Assume that prepaid forward contract price is higher than spot price F 0,T > S 0. Arbitrageur will buy low and sell high by buying the stock for S 0 and selling the prepaid contract for F 0,T Assume that prepaid forward contract price is lower than spot price F 0,T < S 0. Arbitrageur will buy low and sell high by shorting the stock for S 0 and buying the prepaid contract for F 0,T 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 10

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PRICING PREPAID FORWARD WITH DIVIDEND In the case of discrete dividends In the case of continuous dividends where q is the dividend yield 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 11

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FORWARDS CONTRACTS ON STOCK The only difference between prepaid forward contract and forward contract is the timing of the payment for the stock. Thus, the forward price is just the future value of the prepaid forward. If F 0 >S 0 e rT, then arbitrageurs can buy the asset and short forward contract on the asset. If F 0

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FORWARDS CONTRACTS ON STOCK If the stock pays continuous dividends, then the forward price will be Where q is the dividend yield and r is risk free rate. The forward price is higher than spot price because of the cost of financing the spot purchase of the asset during the life of the forward contract. When an investment asset will provide income with a present value of I during the life of a forward contract, we have 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 13

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FORWARD PRICE AND FORWARD PREMIUM Since the has deferred payment, its initial premium is zero, it is initially costless. The forward price, however, is the future value of the prepaid forward price. Forward premium can be defined as the ratio of forward price to the spot price 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 14

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VALUING FORWARD CONTRACTS However, it is important to value the contract each day. Assume that K is the delivery price that was negotiated some time ago, F 0,T is the forward price that would be applicable if we negotiated today, and f is the value of the contract today. Remember, at the beginning of the life of the contract K= F 0,T and f=0. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 15

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FORWARD PRICE AND FORWARD PREMIUM K always stays same since that is the delivery price, but forward price changes. In general, for long forward contract And for all short forward contract 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 16

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DOES FORWARD PRICE PREDICT THE FUTURE PRICE? It is common to think that the forward price reflects an expectation of the assets future price. However forward price conveys no additional information about the expected future spot price Moreover, the forward price systematically errs in predicting the future spot price. When you buy stock You invest money that has a opportunity cost (r) You are acquiring the risk of the stock ( -r), where is expected rate of return. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 17

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DOES FORWARD PRICE PREDICT THE FUTURE PRICE? When you enter into a forward contract, there is no investment, so there is no opportunity cost of money invested However, the forward contract retains the risk of the contract, you must be compensated for risk. This means that the forward contract must earn risk premium. If the risk premium is positive, you expect a positive return from forward contract. The only way this can happen is if the forward price predicts too low a stock price. In other words, the forward contract is a biased predictor of the future stock price. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 18

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DOES FORWARD PRICE PREDICT THE FUTURE PRICE? Let be the expected return and r be the effective annual interest rate The expression ( -r) is the risk premium on the asset. As long as risk premium is different from zero, expected future price will be different from future price. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 19

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FORWARD PRICING FORMULA Forward pricing formula for a stock index Depends on (r-q). This difference is called cost of carry. Forward Price=Spot Price +Interest to carry asset asset lease rate Cost of Carry 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 20

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FORWARD AND FUTURES CONTRACTS ON CURRENCIES Currency futures and forwards contracts are widely used to hedge against changes in exchange rates. Many corporations use currency futures and forwards for short-term hedging. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 21

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FORWARD EXCHANGE RATE (1) Definitions: $ base currency risk-free dollar rate = r risk-free foreign rate = r f time to maturity = T spot exchange rate = S 0 (Home currency/unit of foreign currency) forward exchange rate = F 0T. Consider two strategies for owning 1 unit of foreign currency at T: Strategy A: Buy 1 unit foreign currency forward at 0 at exchange rate F 0T, deposit e -rT /F 0T in dollar risk-free asset, use proceeds to pay for currency at T. Cost = e -rT / F 0T. Strategy B: Buy e -r f T units foreign currency at 0 at exchange rate S 0, invest currency in foreign risk-free asset. Cost = e -r f T / S 0. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 22

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FORWARD EXCHANGE RATE (2) By Arbitrage Principle, the two strategies must cost the same since they both give the same terminal value S T. Hence This is the Covered Interest Parity (CIP) condition: if the domestic interest rate exceeds the dollar rate (r>r f ), the domestic currency will be seen as depreciating (F 0T > S 0 ). The only reason US pays higher interest is the fact that US currency is expected to depreciate. To compensate US $ holder, US pays higher interest rate. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 23

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FOREIGN EXCHANGE RATE Example: Suppose that euro-denominated interest rate is 3% and dollar-denominated rate is 1%. The current exchange rate is 1.47 dollar per euro. The one-year forward rate Thus if r

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COMMODITY FORWARDS AND FUTURES On any given day, for many commodities there are futures contract available that expire in a number of different months. The set of prices for different expiration dates for a given commodity is called the forward curve or forward strip. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 25

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FUTURES MONTHS ABBREVIATION 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 26

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CL: LIGHT SWEET OIL 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 27

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FORWARD CURVE: CL 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 28

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FORWARD CURVE Let us assume 1 year LIBOR rate 1.27% on September 22, 2009. From October 2009 to October 2010, CL price rose from 71.55 to 76.36 or 6.72%, far in excess of 1.27%. In the context of the formula for pricing financial forwards, we would need to have continuous dividend yield, q, of -5.23% in order to explain this rise in the forward price over time. In that case we would have How do we interpret negative dividend? 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 29

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COMMODITIES Even more puzzling, sometimes we can see future prices will decline with time to expiration. It is possible to explain this behaviour by specific commodity market, e.g. harvesting time in corn or war in Iraq reduce the supply of oil in spot market but expectation for future is more optimistic. The behaviour of forward prices can vary over time. When forward curve is upward sloping then we say the market is in contango. If the forward curve is downward sloping then we say market is in backwardation. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 30

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FORWARD COMMODITY PRICES (1) Definitions: as before plus Storage costs (they can be regarded as negative income) = u (continuos rate) Gold and Silver: F 0T = S 0 e rT (if u = 0), Gold and Silver can be considered as securities paying no income F 0T = S 0 e (r + u)T (if u 0). Other Commodities: In this case we can only establish an inequality: F 0T S 0 e (r + u)T. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 31

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FORWARD COMMODITY PRICES (2) Suppose F 0T > S 0 e (r + u)T. Sell 1 unit commodity forward at F 0T Buy e uT units spot at S 0 and pay for the storage costs Riskless profit = e -rT F 0T - e uT S 0 = e -rT (F 0T - e (r + u)T S 0 ). It implies that F 0T S 0 e (r + u)T. Suppose F 0T < S 0 e (r + u)T. This suggests buying forward and selling spot Industrial users (they are reluctant to sell commodity and buy futures contracts since futures contracts cannot be consumed). All we can assert for commodity is: F 0T S 0 e (r + u)T. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 32

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CONVENIENCE YIELD Business reasons for holding commodities: nonmonetary return that is sometimes referred to as convenience yield. where y represent the convenience yield. The convenience yield reflects the markets expectations concerning the availability of the commodity. The greater the possibility that shortages will occur, the higher the convenience yield. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 33

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FORWARD VS FUTURES PRICES Forward and futures prices are usually assumed to be the same. When interest rates are uncertain they are, in theory, slightly different 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 34

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COMMODITY SPREADS Some commodities are inputs of other commodities, which gives rise to commodity spreads. Soybeans, for example, can be crushed to produce soybean meal and soybean oil. A trader with a position in soybeans and opposite position in equivalent quantities of soybean oil has a crush spread and is said to be trading the crush. Similarly, crude oil is refined to make petroleum products, in particular heating oil and gasoline. The split of oil into these different components can be complemented by a process known as cracking, hence the difference in price between crude oil and equivalent amounts of heating oil and gasoline is called crack spread. 9/16/2009BAHATTIN BUYUKSAHIN, CELSO BRUNETTI 35